Written on the occasion of Warren Buffett’s 93rd birthday (8/30/23):
The game taught me the game – Jesse Livermore
There are four perennial approaches to the stock game: value, macro, momentum and technical.
Value investing was founded by Ben Graham with the publication of Security Analysis in 1934. In 1949 Graham published a more popular treatment of the subject, The Intelligent Investor. Graham was the first to advise analyzing a company’s fundamentals rather than relying on reading the tape or insider tips. Graham was concerned with what could be reasonably measured in the present: current earnings, cash on the balance sheet, physical assets. This mostly led him to “cigar butts” i.e. declining businesses whose assets minus liabilities exceeded the current stock price.
Warren Buffett was a Graham disciple in his early years but ultimately transcended classical value investing. That’s because buying quantitatively cheap companies – usually based on the Price to Earnings ratio – frequently failed because it inclined toward value traps. In the 1987 Berkshire Hathaway Annual Report Buffett wrote this of his early investment style: “My punishment was an education in the economics of short-line farm implement manufacturers, third-place department stores, and New England Textile manufacturers.”
Buffett’s investment in Coke in 1988 was the defining moment of his evolution. Graham diehards thought that Buffett had given up the faith by paying 15 times earnings – a 30% premium to the market averages at the time. In 1989, Buffett had a $1 billion stake in Coke representing one third of Berkshire’s portfolio. In making this investment, Buffett moved away from focusing on current value factors toward emphasizing future value factors. In other words, he recognized that the true value of a business is based on the present value of all future cash flows – not just the very near ones. This moved him away from value traps and toward quality businesses that could grow and compound. It was the pivot that made him the greatest investor of all time and greatly contributed to the evolution of value investing.
The most recent example of his evolution is the 2016 investment in Apple which had grown to a $119 billion position at the end of 2022 – similar in relation to the overall portfolio to the Coke position in 1989. (I have my concerns that Buffett may overstay his welcome in Apple; see “An Open Letter To Warren Buffett Re: AAPL”, August 3, 2023). Robert Hagstrom has done yeoman’s work chronicling Buffett’s evolution in superb books like The Warren Buffet Way (1994) and Warren Buffett: Inside The Ultimate Money Mind (2021).
Before Graham and Buffett, there was Jesse Livermore whose trading career and philosophy was captured in Reminiscences Of A Stock Operator, published in 1923. Jesse started off as a tape reader, trading in and out of stocks based on his feel for the tape. His mature philosophy – however – was to focus on “general conditions” and the primary trend. He learned not to concern himself with the daily fluctuations but to be focused on the bigger picture and trend: “The big money is not in the individual fluctuations but in the main movements – that is, not in reading the tape but in sizing up the entire market and its trend” (Reminiscences, Chapter V). In other words, Jesse wanted to be long in bull markets and short in bear markets. The defining moment of Jesse’s career was when he shorted the market in 1929. He had been bearish on the market for quite some time but got run over every time he tried to short. Until October when the market crashed and he made $100 million in one week.
In recent decades, momentum investing has become quite popular. The book that inaugurated this style is William O’Neil’s How To Make Money In Stocks, published in 1988. O’Neil was also the founder of Investor’s Business Daily which applied his philosophy to the market on a daily basis. O’Neil created an acronym – CANSLIM – which stood for the seven factors investors should focus on in stocks: Current and Annual earnings; New products; Supply of shares; Leaders; Institutional ownership; and the overall Market. In practice, O’Neil focused on stocks with high relative strength i.e. the stocks that were performing best at the moment. The greatest modern practitioner of momentum investing is Mark Minervini, author of Trade Like A Stock Market Wizard (2013) (I reviewed the book shortly after it came out: “A New Investment Classic”, November 3, 2013).
Momentum is the best way to make money fast. It’s also the best way to lose money fast. Its strength is being where the action is and owning the best performing stocks. Its weakness is frequently failing to distinguish between fads and sustainable trends. Being successful at this style means being able to ride the popular stocks of the moment while cutting losses quickly to avoid giving back all your gains when the party ends. Minervini – for example – places great emphasis on the discipline of quickly cutting one’s losers.
Finally, there is technical analysis. Technical analysis eschews fundamentals in favor of price and various derivatives. Technicians buy stocks in uptrends and avoid stocks in downtrends. They use derivatives of price such as moving averages, support and resistance, relative strength and many other more complex and obscure indicators. The premise of technical analysis is that trends persist. The criticism is that the past is no guarantee of the future. In my opinion, technical analysis is mainly history. It tells you what has happened but almost nothing about what is going to happen.